Why an investor needs a game plan

29 September 2017
by
National Bank

Investing isn’t the place to improvise. That’s why it’s important
to have a good game plan, adapted to your goals and investor
profile. Once these guidelines are established they can also help
you avoid an investor’s worst enemy: emotion.

As an investor, not only do you need to exercise discipline, but you
also need to establish a game plan that you commit to following
scrupulously. This plan can help you reach your goals, while keeping a
cool head when your emotions might lead you to make mistakes. Here’s a
short guide to the steps to follow and traps to avoid.

What is a game plan?

Annamaria Testani, Vice President of National Sales at National Bank
Investments, compares it to a photo that a financial planning expert
might take of your situation at a specific moment in time, in order to
make more informed decisions going forward. “It’s similar to a doctor
assessing your health to pinpoint a particular problem. The main idea
is to analyse the initial situation and determine what the ultimate
goal is,” she explains. “When we don’t have a plan, we’re less aware
of the mistakes we make and it can be a lot harder to correct them.”

In addition to solid planning, she recommends basing your strategy on
systematic investment and saving.
“There’s no magic formula for achieving your financial goals. Since
past returns are no guarantee of future returns, you need to be
disciplined. It pays off in the long term. No one should be expecting
a miracle recipe that will produce remarkable results in the short
term,” she says.

An advisor or financial planner can help you put this famous plan
together. “I am an enormous believer in the value of getting advice,”
Annamaria Testani asserts. “Personally, even though I work in finance,
I don’t hesitate to surround myself with experts to help me make the
right decisions.”

Preventing the impact of emotion

Because it pushes us to follow certain guidelines, a good game plan
also helps protect us… from ourselves. That’s because a large number
of the bad financial decisions investors make are made on the basis of
emotion: worry generated by weakened markets and stock market
corrections, or on the flip side, optimism and over-confidence, a
refusal to lose, and too-fast or too-slow decision-making are all
situations that can lead to emotion in an investment context.

In fact, most of us have a hard time managing the psychological
aspects of managing our investments. The study of investor psychology
has given rise to what we today call behavioural finance. In other
words, the way people make financial decisions and evaluate
prospective losses or gains.

At the end of the 1970s, two researchers developed something called
prospect theory. According to psychologists Daniel Kahneman and Amos
Tversky, we adopt different, irrational behaviours when faced with
prospective losses or gains. The theory states that people have a hard
time accepting the frustration provoked by financial losses on the
stock market, and are prepared to take higher, unreasonable risks to
avoid this. But there’s more. The researchers observed that the
prospect of a financial loss is not mitigated by that of a comparable
gain, and that a loss creates a greater emotional reaction than an
equivalent gain.

So, a person would generally prefer to gain $100 than to gain $200
and lose $100, even though the net result of both situations is the
same. This allergy to loss can lead investors to uncharacteristic
risk-taking behaviour: they’ll hold onto a dropping stock longer than
they should in the hopes it will bounce back, rather than limiting
their losses by selling immediately. Furthermore, faced with a risky
choice that could lead to gains, an investor is likely to choose an
investment producing a lower return but that is more secure. So, an
investor who needs to invest $1,000 would prefer a 100% chance of
gaining $500 than a 50% chance of receiving $1,000 and 50% risk of
making no profit.

Time and confidence

The other important impact of emotion on investors’ decisions
concerns confidence, and the time it takes to establish it. For
example, when the market seems weak and uncertain, we have a tendency
to stop investing until our confidence is re-established – this is
generally when the market shows certain signs of improvement. This
leads us to buy stocks at the exact moment when they are in highest
demand, and when we head back into a down cycle and their value drops
again, we once again exit the market… up until the cycle turns back up
again. When we take too long to decide to buy, we miss out on the full
potential gains our stock purchase represents. Result: we make
investments that go against the flow of economic cycles.

Opportunism and extreme risk-taking

The other thing that psychology teaches us about this is that
investors, even if they are generally prudent, will behave
opportunistically and take more risk than usual when they want to make
a rapid gain on their stocks, then resell. By doing so, they put
themselves in a position counter to their goals, and are using the
stock market like a casino. Yet, the events that influence the
prospective return of a stock are many and unpredictable, and
investors are at great risk of making a mistake in their projections.

Lessons we should all take to heart, so as not to be led by our emotions…

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National Bank Direct Brokerage (NBDB) is a division of National Bank Financial Inc. (NBF) as well as a trademark used by NBF. NBF is a member of the Investment Industry Regulatory Organization of Canada and the Canadian Investor Protection Fund. NBF is a wholly-owned subsidiary of National Bank of Canada, a public company listed on the Toronto Stock Exchange (TSX: NA). NBDB provides order execution only services and makes no investment recommendations. Clients are solely responsible for the financial and tax consequences of their investment decisions.